Tuesday, April 26, 2016

Canadians will all know what Canadian Tire Money is, but American and overseas readers might not. Canadian Tire, one of Canada's largest retailers, defies easy categorization, selling everything from tents to lawn furniture to hockey sticks to car tires. Since 1958, it has been issuing something called Canadian Tire Money (see picture above). These paper notes are printed in denominations of up to $2 and are redeemable at face value in kind at any Canadian Tire store.

Because there's a store in almost every sizable Canadian town, and the average Canadian make a couple visits each year, Canadian Tire money has become ubiquitous—everyone has some stashed in their cupboard somewhere. Many Canadians are quite fond of the stuff—there's even a collectors club devoted to it. I confess I'm not a big fan: Canadian Tire money is form of monetary pollution, say like bitcoin dust or the one-cent coin. I just throw it away.

It's the monetary oddities that teach us the most about monetary phenomena, which is why I find Canadian Tire money interesting. Here's an observation: despite the fact that it is ubiquitous, looks like money, trades at par, and is backed by a reputable issuer, Canadian Tire money doesn't circulate much. Stephen Williamson, a Canadian econ blogger, had an entertaining blog post a few years back recounting unsuccessful efforts to offload the coupons on Canadians. Sure, from time to time we might encounter the odd bar or charity that accepts it, or maybe a corner-store in Wawa. But apart from Canadian Tire stores, acceptability of Canadian Tire money is the exception, not the rule.

Why hasn't Canadian Tire money become a generally-accepted medium of exchange? One explanation is that Canadian law prevents it. Were the government to remove the strict rules that limit the ability of the private sector to issue paper money, bits of Canadian Tire paper would soon be circulating all across the nation, maybe even displacing the Bank of Canada's paper money.

A second hypothesis is that even if the law were to be loosened, Canadian Tire would remain an unpopular exchange medium. Some deficiency with Canadian Tire money, and not strict laws, drives their lack of liquidity. Nick Rowe, another Canadian econ blogger (notice a theme here?), once speculated that this had to do with network effects. Canadians have long since adopted the convention of using regular Bank of Canada-issued notes, and overturning that convention by accepting Canadian Tire money would be too costly. David Andolfatto (not another Canadian econ blogger!), would probably point to limited commitment as the deficiency. IOUs issued by Canadian Tire simply can't be trusted as much as government money, and so they inevitably fail as a medium of exchange.

In support of the first view, which is known in the economics literature as the legal restrictions hypothesis, Neil Wallace and Martin Eichenbaum (yep, another Canadian) recount an interesting anecdote. Back in 1983, competitor Ro-Na (since renamed RONA), a major hardware chain, started to accept Canadian Tire coupons at face value. I've found an old advertisement of the offer below:

Eichenbaum and Wallace say that this is evidence that Canadian Tire money isn't just a mere coupon but readily serves as a competitive medium of exchange among Canadians. After all, if a major store like RONA accepted the coupons, then their acceptance wasn't just particular—it was general.

The story doesn't end there. Here is an interesting 1983 article from the Montreal Gazette:

The article mentions how in retaliation Canadian Tire sought an injunction against RONA to prevent it from accepting Canadian Tire money. We know this tactic must have been somewhat successful since RONA does not currently accept said coupons. Eichenbaum & Wallace slot this into their legal restrictions theory, noting that the injunction was probably motivated by Canadian Tire's desire to comply with legal prohibitions on the private issuance of currency, a damaging law suit helping to inhibit general use of their coupons. Remove these legal restrictions, however, and Canadian Tire would probably not have sued RONA, and usage of Canadian Tire coupons as a medium of exchange would have expanded. Presumably if Tim Horton's took up the baton from RONA and accepted Canadian Tire money, and then Couche-Tard joined in, you'd end up with a new national currency.

So we have two competing theories to explain Canadian Tire money's lack of acceptability. Which one is right? Let's introduce one more story arc. Zoom forward to 2009 when Canadian Tire lawyers sent a notice to a NAPA car parts dealer asking him to stop accepting Canadian Tire money. The reason cited by Canadian Tire: trademark infringement. As the article points out, Canadian Tire Money constitutes intellectual property, and if companies do not sufficiently police their trademarks against general usage, they may lose control of them. For instance, over the years Johnson & Johnson has had to vigorously defend its exclusive rights to the name "Band-Aid." If it hadn't, it might have lost claim to the name in the same way that Otis Elevator lost its trademark on the word "escalator" because the word fell into general use. That the 1983 RONA challenge probably had less to do with currency laws than trademark infringement damages Eichenbaum &Wallace's argument.

The last interesting Canadian factoid is the observation that a number of community currencies circulate in Canada. Salt Spring dollars, a currency issued by the Salt Spring Island Monetary Foundation, located off the coast of British Columbia, is one of these. Other examples include Calgary Dollars and Toronto Dollars. According to Johanna McBurnie, Salt Spring dollars are legal because they are classified as gift certificates. If so, I don't see why the use of Canadian Tire money as a medium of exchange wouldn't fall under the same rubric. This puts the final nail in Wallace & Eichenbaum's argument that restrictions on circulation of competing paper money have prevented broad usage of Canadian Tire paper. Rather, if laws are to blame for the minimal role of Canadian Tire Money's as currency, then it is the company's desire to protect its trademark that is at fault.

That local IOUs like Salt Spring dollars can legally circulate but lack wide acceptance (even in the locality in which they are issued) means we need something like the Nick Rowe's network effects or David Andolfatto's limited commitment to explain why incumbent paper money tends to exclude competing paper money from circulation. Which isn't to say that Canadian Tire money would never circulate. As Larry White and George Selgin have pointed out, private paper money has circulated along with government paper money in places like Canada. But the bar for Canadian Tire money is probably a high one.

Wednesday, April 20, 2016

Imagine waking up in the morning and checking the hockey scores, news, the weather, and how much the central bank has adjusted the gold content of the dollar overnight. This is what a 21st century gold standard would look like.

Central banks that have operated old fashioned gold standards don't modify the gold price. Rather, they maintain a gold window through which they redeem a constant amount of central bank notes and deposits with gold, say $1200 per ounce of gold, or equivalently $1 with 0.36 grains. And that price stays fixed forever.

Because gold is a volatile commodity, linking a nation's unit of account to it can be hazardous. When a mine unexpectedly shuts down in some remote part of the world, the necessary price adjustments to accommodate the sudden shortage must be born by all those economies that use a gold-based unit of account in the form of deflation. Alternatively, if a new technology for mining gold is discovered, the reduction in the real price of gold is felt by gold-based economies via inflation.

Here's a modern fix that still includes gold. Rather than redeeming dollar bills and deposits with a permanently fixed quantity of gold, a central bank redeems dollars with whatever amount of gold approximates a fixed basket of consumer goods. This means that your dollar might be exchangeable for 0.34 grains one day at the gold window, or 0.41 the next. Regardless, it will always purchase the same consumer basket.

Under a variable gold dollar scheme the shuttering of a large gold mine won't have any effect on the general price level. As the price of gold begins to skyrocket, consumer prices--the reciprocal of a gold-linked dollar--will start to plummet. The central bank offsets this shock by simply redefining the dollar to contain less gold grains than before. With each grain in the dollar more valuable but the dollar containing fewer grains of the yellow metal, the dollar's intrinsic value remains constant. This shelters the general price level from deflation.

This was Irving Fisher's 1911 compensated dollar plan (see chapter 13 of the Purchasing Power of Money), the idea being to 'compensate' for changes in gold's purchasing power by modifying the gold content of the dollar. A 1% increase in consumer prices was to be counterbalanced by a ~1% increase in the number of gold grains the dollar, and vice versa. Fisher referred to this fluctuating definition as the 'virtual dollar':

Fisher acknowledged that 'embarrassing' speculation was one of the faults of the system. Say the government's consumer price report is to be published tomorrow and everyone knows ahead of time that the number will show that prices are rising too slow. And therefore, the public expects that the central bank will have to increase its gold buying price tomorrow, or, put differently, devalue the virtual dollar so it is worth fewer ounces of gold. As such, everyone will rush to exchange dollars for gold at the gold window ahead of the announcement and sell back the gold tomorrow at the higher price. The central bank becomes a patsy.

Fisher's suggested fix was to introduce transaction costs, namely by setting a wide difference between the price at which the central bank bought and sold gold. This would make it too expensive buy gold one day and sell it the next. This wasn't a perfect fix because if the price of gold had to be adjusted by a large margin the next day in order to keep prices even, say because a financial crisis had hit, then even with transaction costs it would still be profitable to game the system.

A more modern fix would be to adjust the gold content of the virtual dollar in real-time in order to remove the window of opportunity for profitable speculation. Given that consumer prices are not reported in real-time, how can the central bank arrive at the proper real-time gold price? David Glasner once suggested targeting the expectation. Rather than aiming at an inflation target, the central bank targets a real-time market-based indicator of inflation expectations, say the TIPS spread. So if inflation expectations rise above a target of 2% for a few moments, a central bank algorithm rapidly reduces its gold buying price until expectations fall back to target. Conversely, if expectations suddenly dip below target, over the next few seconds the algorithm will quickly ratchet down the content of gold in the dollar to whatever quantity is sufficient to restore the target (i.e. it increases the price of gold).

Gold purists will complain that this is a gold standard in name only. And they wouldn't be entirely wrong. Instead of defining the dollar in terms of gold, a compensated dollar scheme could just as well define it as a varying quantity of S&P 500 ETF units, euros, 10-year Treasury bonds, or any other asset. No matter what instrument is being used, the principles of the system would be the same.

A compensated dollar scheme isn't just a historical curiosity; it may have some relevance in our current low-interest rate environment. Lars Christensen and Nick Rowe have pointed out that one advantage of Fisher's plan is that it isn't plagued by the zero lower bound problem. Our current system depends on an interest rate as its main tool for controlling prices. But once the interest rate that a central bank pays on deposits has fallen below 0%, the public begins to convert all negative-yielding deposits into 0% yielding cash. At this point, any further attempt to fight a deflation with rate cuts is not possible. The central banker's ability to regulate the purchasing power of money has broken down.*

Under a Fisher scheme the tool that is used to control purchasing power is the price of gold, or the gold content of the virtual dollar, not an interest rate. And since the price of gold can rise or fall forever (or alternatively, a dollars gold content can always grow or fall), the scheme never loses its potency.

Ok, that is not entirely correct. In the same way that our modern system can be crippled under a certain set of circumstances (negative rates and a run into cash), a Fisherian compensated dollar plan had its own Achilles heel. If gold coins circulate along with paper money and deposits, then every time the central bank reduces the gold content of the virtual dollar in order to offset deflation it will have to simultaneously call in and remint every coin in circulation in order to keep the gold content of the coinage in line with notes and deposits. This series of recoinages would be a hugely inconvenient and expensive.

If the central bank puts off the necessary recoinage, a compensated dollar scheme can get downright dangerous. Say that consumer prices are falling too fast (i.e. the dollar is getting too valuable) such that the central banker has to compensate by reducing the gold content of the virtual dollar from 0.36 grains to 0.18 grains (I only choose such a large drop because it is convenient to do the math). Put differently, it needs to double the gold price to $2800/oz from $1400. Since the central bank chooses to avoid a recoinage, circulating gold coins still contain 0.36 grains.

The public will start to engage in an arbitrage trade at the expense of the central bank that goes like this: melt down a coin with 0.36 grains and bring the gold bullion to the central bank to have it minted into two coins, each with 0.36 grains (remember, the central bank promises to turn 0.18 grains into a dollar, whether that be a dollar bill, a dollar deposit, or a dollar coin, and vice versa). Next, melt down those two coins and take the resulting 0.72 grains to the mint to be turned into four coins. An individual now owns 1.44 grains, each coin with 0.36 grains. Wash and repeat. To combat this gaming of the system the government will declare the melting-down of coin illegal, but preventing people from running garage-based smelters would be pretty much impossible. The inevitable conclusion is that the public increases their stash of gold exponentially until the central bank goes bankrupt.

This means that a central bank on a compensated dollar that issues gold coins along with notes/deposits will never be able to fight off a deflation. After all, if it follows its rule and reduces the gold content of the virtual dollar below the coin lower bound, or the number of grains of gold in coin, the central bank implodes. This is the same sort of deflationary impotence that a modern rate-setting central bank faces in the context of the zero lower bound to interest rates.

In our modern system, one way to get rid of the zero lower bound is to ban cash, or at least stop printing it. Likewise, in Fisher's system, getting rid of gold coins (or at least closing the mint and letting existing coin stay in circulation) would remove the coin lower bound and restore the potency of a central bank. Fisher himself was amenable to the idea of removing coins altogether. In today's world, the drawbacks of a compensated dollar plan are less salient as gold coins have by-and-large given way to notes and small base metal tokens.

In addition to evading the lower bound problem, a compensated dollar plan would also be better than a string of perpetually useless quantitative easing programs. The problem with quantitative easing is that commitments to purchase, while substantial in size, are not made at any particular price, and therefore private investors can easily trade against the purchases and nullify their effect. The result is that the market price of assets purchased will be pretty much the same whether QE is implemented or not. Engaging in QE is sort of like trying to change the direction of the wind by waving a flag, or, as Miles Kimball once said, moving the economy with a giant fan. A compensated dollar plan directly modifies the price of gold, or, alternatively, the gold content of the dollar, and therefore has an immediate and unambiguous effect on purchasing power. If central bankers adopted Fisher's plan, no one would ever accuse them of powerlessness again.

*Technically, interest rates need never lose their potency if Miles Kimball's crawling peg plan is adopted. See here.

Saturday, April 9, 2016

Passive investing is eating Wall Street. According to 2015 Morningstar data, while actively managed mutual funds charge clients 1.08% of each dollar invested per year, passively managed funds levy just a third of that, 0.37%. As the public continues to rebalance out of mutual funds and into index ETFs, Wall Street firms simply won't be able to generate sufficient revenues to support the same number of analysts, salespeople, lawyers, journalists, and other assorted hangers-on. It could be a bloodbath.

Any firm that faces declining profits due to narrowing margins can restore a degree of profitability by driving more business through its platform. In the case of Wall Street, that means arm-twisting investors into holding even more investment products. If Gordon Gecko can get Joe to hold $3000 worth of low margin ETFs then he'll be able to make just as much off Joe as he did when Joe held just $1000 in high margin mutual funds.

How to get Joe to hold more investments? One way would be to increase demand for ETFs by making them more money-like. Imagine it was possible to pay for a $2.00 coffee with $2.00 worth of SPDR S&P 500 ETF units. Say that this payment could occur instantaneously, just like a credit card transaction, and at very low cost. The coffee shop could either keep the ETF units as an investment, pass the units off as small change to the next customer, use them to buy coffee beans from a supplier, or exchange them for a less risky asset.

In this scenario, ETF units would look similar to shares of a money market mutual fund (MMMF). An MMMF invests client money in corporate and government debt instruments and provides clients with debit and cheque payments services. When someone pays using an MMMF cheque or debit card, actual MMMF shares are not being exchanged. Rather, the shares are first liquidated and then the payment is routed through the regular payments system.

Rather than copying MMMFs and integrating ETFs into the existing payment system, one idea would be to embed an ETF in a blockchain, a distributed digital ledger. Each ETF unit would be divisible into thousandths and capable of being transferred to anyone with the appropriate wallet in just a few moments. One interesting model is BitShares, provider of the world's first distributed fully-backed tracking funds (bitUSD tracks the U.S. dollar, bitGold tracks gold, BitCNY the yuan, and more). I wrote about bitUSD here. Efforts to put conventional securities on permissioned blockchains for the purpose of clearing and settlement are also a step in this direction.

Were ETFs were to become a decent medium of exchange, people like Joe would be willing to skimp on competing liquid instruments like cash and bank deposits and hold more ETFs. If so, investment managers would be invading the turf of bankers who have, until now, succeeded in monopolizing the business of converting illiquid assets into money (apart from money market mutual fund managers, who have tried but are flagging).

Taken to the extreme, the complete displacement of deposits as money by ETFs would get us to something called narrow banking. Right now, bankers lend new deposits into existence. Should ETFs become the only means of payment, there would be no demand for deposits and bankers would have to raise money in the form of ETFs prior to making a loan. Bank runs would no longer exist. Unlike deposits, which provide fixed convertibility, ETF prices float, thus accommodating sudden drops in demand. In other words, an ETF manager will always have just enough assets to back each ETF unit.

Two problems might emerge. Money is very much like an insurance policy—we want to know that it will be there when we run into problems. While stocks and bonds are attractive relative to cash and deposits because they provide superior returns over the long term, in the short term they are volatile and thus do not make for trustworthy money. If we need to patch a leaky roof, and the market just crashed, we may not have ETF units enough on hand. Cash, however, is usually an economy's most stable asset. So while liquid ETFs might reduce the demand for deposits, its hard to imagine them displacing traditional banking products entirely.

A fungibility problem would also arise. Bank deposits are homogeneous. Because all banks accept each others deposits at par and these deposits are all backed by government deposit insurance, we can be sure that one deposit is as good as another. And that homogeneity, or fungibility, means that deposits are a great way to do business. ETFs, on the other hand, are heterogeneous. They trade at different prices and follow different indexes. Shopkeepers will have to pause and evaluate each ETF unit that customers offer them. And that slows down monetary exchange—not a good thing.

Somewhat mitigating ETF's fungibility problem is the fact that the biggest ETFs track the same indexes. On the equity side, three of the six largest ETFs track the S&P 500 while on the bond side, the two largest ETFs track the Barclays Capital U.S. Aggregate Bond Index. Rather than just any ETF becoming generally accepted media of exchange, the market might select those that track the two or three most popular indexes.

In writing this post, I risk being accused of blockchain magical thinking—distributed ledgers haven't yet proven themselves in the real world. All sorts of traditions and laws would have to be upended to bring the world of securities onto a distributed ledger. Nevertheless, it'll be interesting to see how the fund management industry manages to squirm out of what will only become an increasingly tighter spot. Making ETFs more liquid is an option, though surely not the only one.

PS. Here is the blogosphere's own Tyler Cowen (along with Randall Kroszner) on "mutual fund banking" in 1990:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

With the rise of ETFs and blockchain technology, the modern version of mutual fund banking would be something like distributed ETF banking described in the above post,